By Neil Morris and Christopher Lombardy -- Hedge fund managers need to step up their game in order to compete effectively in today’s era of increasingly savvy investors. Amid the backdrop of recent high profile frauds, historic market declines, and related fund closures, the hedge fund industry faces a new set of concerns emanating from the heightened emphasis on investor due diligence.

Victims of Bernie Madoff’s Ponzi scheme lost an estimated $50 billion, businessman Tom Petters’ fraud scheme cost investors approximately $3.5 billion, and the Bear Stearns fiasco resulted in a $1.5 billion loss. In addition, let’s not forget names such as Bayou, Beacon Hill, Lancer, Lipper & Company and Philadelphia Alternative Asset Management. The list goes on, and includes types of fraud ranging from Ponzi schemes and misappropriation of fund assets to mis-valuations and misrepresentations.

Clearly, the days of lackluster hedge fund due diligence are over. High net worth and institutional investors alike are clear on the need to heed the warning signs that a fund may not be implementing best practices in all aspects of its operation.

What are the best ways to avoid hedge fund fraud? Prospective investors need to beware of funds with few points of detection (eg. annual external audit, outside administrators), realize that a “blow up” can occur quickly, and be cautious of virtual organizations, complex structures and unnecessary opacity – both in terms of investors and strategy.

In retrospect, many of the recent frauds should have been easy to detect, but for many reasons, they were not brought to light until much harm had been done. In the end, one’s gut feeling is important; however, the following are clear red flags that a fund may be in trouble sooner rather than later.

• Lack of or Weak Valuation Policy – significant attention needs to be paid to valuation as a component of operational risk issues in a hedge fund. All funds, regardless of size or strategy should have well documented processes for valuing the assets of the fund. Furthermore, a clear and consistent application of the process should be evident.

• Substantial Change in Assets Under Management – A substantial change in AUM should be considered a potential warning sign that operational capabilities may be strained, or that the fund may be an “asset gatherer” versus an “asset manager.”

• Personnel Concerns - lack of segregation of duties, especially related to cash controls, as well as turnover of key personnel, should be reviewed carefully.

• Establishment of Side Pocket Investments – the use of side pockets has been a reality at hedge funds for many years, but is of increasing concern to regulators and investors during the recent market volatility and uptick of fund restructurings.

• Strategy/Style Drift – investors should steer clear of hedge fund managers that cannot clearly articulate and follow the stated strategy. If a change in strategy occurs, it should be communicated promptly to investors with appropriate support for the decision provided.

• Change in Leverage Amount – dramatic changes in leverage have the potential to multiply losses, or at the very least, complicate the accounting and operational controls around cash, margin requirements and counterparty management.

• Counterparty Concentration – recent experience with problems at Lehman and Bear Stearns have amplified the risks associated with limiting trade allocations to one counterparty.

• Unknown or Affiliated Service Providers – this should have been a clear red flag in the Madoff case, but went unnoticed for many years. Recent changes in service providers that are not justified with a clear explanation are also potentially problematic.

• Outdated Legal Documents – all fund documents need to be aligned; for example, longer lock-ups may require changes to the fee structure. Every change to a document requires a close look at all others. The provision of outdated or inconsistent documents may indicate a lack of proper corporate governance.

• Matching of Fund Liquidity vis-a-vis Underlying Portfolio Liquidity – when the music stops and people want out, it is problematic unless underlying assets reconcile with liquidity offered to investors.

• Lack of Supervisory or Best Practices Policies and Procedures – missed regulatory filing deadlines and sloppy record-keeping are cause for concern; best practices must be exemplified in all areas.

• Inability to Communicate Processes Clearly and Thoroughly – the manager and all staff should be well-versed in all aspects of the fund, its investment process, and its strategy.

These represent only a few of the red flags that should alert investors to potential operational weaknesses, and in the worst cases, may indicate the existence of fraud. However, any investment in hedge funds should include a comprehensive review of all aspects of the manager’s business operations, including; background checks for each of the principal members of the management firm, a legal review of all constituent documents, a complete discussion and understanding of the trading strategy and risk management procedures, and a thorough analysis of the operational and accounting controls.

Neil Morris and Christopher Lombardy are partners in the New York office of Kinetic Partners, a global professional services firm providing audit and assurance, tax, regulatory risk and compliance, corporate recovery, forensic and corporate finance services to the asset management industry.

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